LEVERAGE, COST OF CAPITAL AND BANK VALUATION

Abstract

In this paper, we present a model that demonstrates the effect of debt on cost of capital and value in the case of banking firms. Using a static partial equilibrium setting, both in a steady state and steady growth scenario, we derive a bank-specific valuation metric which separately attributes value to assets and debt cash flows in the form of a liquidity premium and tax-shield. We run our model on a sample of the largest 26 European banks from 2003 to 2016 finding that the value contribution of debt benefits to enterprise value is large and persistent. Further from our model, we derived an implied cost of capital (ICC) measure finding consistent results with capital asset pricing model (CAPM). The theoretical framework we present is helpful to address bank debt benefits valuation and to reconcile equity and asset side approaches.

Keywords

• bank valuation
• capital structure
• cost of capital
• liquidity premium
• taxes